By J.V. Rizzi

Making Sense of Increased Capital Requirements

The opinions expressed herein are those of the author.They do not reflect the views of CapGen Financial.

Risk MindsJune 2012

Table of ContentsChangeReactionRealityImpactResponseConclusion

2

Change

3

The Change(BIS III and Dodd Frank)

Message: more capital, more liquidity and less risk Specifics

- tightened capital definition- increased RWA weights- more liquidity

limit illiquid assetsrestrict unstable funding

- increased capital requirementsBIS III Dodd Frank (well capitalized)

CE 2 4.5 [5+]T1 4 6 > 6TC 8 8 > 10Buffer 0 2.5 --Lev 0 3 > 5

Why- Banking as an industry failed- Clear that prior capital rules were insufficient

4

(Capital goes where it is welcome…

…and stays where it is treated well)

Reaction

5

The Nonsense(Do you want to believe what you see…Higher Capital Requirements

Put aside more reservesCurtail lendingImpede growth

Decrease ROEIncreased Funding CostUn-American

…or what I am telling you?)

6

Reality

7

The Reality(Facts ignored… Set aside

Confuses liquidity reserves with funding mix Increased funding cost

Limited given proportion of equity in capital structure Ignores cost of forced capital raise at distressed price

Reduced ROE Cost of equity is not fixed Key is the spread between ROE and cost of equity

Un-American “The policy goal should be a healthier banking system, rather than high

returns for banks’ shareholders and managers with taxpayers picking up the losses and economies suffering the fallout.”

Bankers resistance of higher capital requirements: capital shifts risk from taxpayer to capital provider Vested interest in subsidies and compensation– especially for banks with

weak franchise value and Debt overhang: benefits to debtholders

…do not cease to exist.)

8

Impact

9

Impact(You cannot lever up a sow’s ear into a silk purse…Business Model

Balance sheet mixCapital generation and growth

Shareholder distributionsRestructuring

ShrinkBreak-up Merge

Capital structure…you may think you can during the good

times, but…)

10

CAPITAL STRUCTURE

11

Stakeholder Views of Capital Differ

12

Capital focus is primarily on tangible equity capital and capital replenishment capabilities.

Concern on through the cycle capital and buffers

Are focused on capital discipline and allocation

Capital Returns and bonuses

Rating Agencies

Regulators

Shareholders

(Is the glass half full or half empty…

… it depends on whether you are pouring or drinking)

Management

Introduction (Once set…

13

Return Opportuni

ties

Governance

Volatility LiquidityStrategic CapitalBudgeting (CEO)

Correlations

Risk Management

(CRO)Risk Appetite

Capabilities

External Stakeholders

ShareholdersRisk/Return Regulators

Performance

Capital StructureCFO

Rating Agencies

…Capital structure is continuously monitored and revised)

Overview(Capital structure is important not because it creates value…

Set capital structure independent of regulation Except for banks with limited franchise value and suffering from debt

overhang Enough capital to pursue strategy and weather cash flow shortfall

Positive relationship between value and equity thru the cycle Long term decline from insufficient capital going into crisis outweighs short

term leverage benefit Major determinant of capital is the market and rating agencies

Most banks hold more than regulatory minimum Framework

Estimate financing surplus or deficit through the cycle Surplus- shareholder distributions Deficit- raise additional capital

Ratings requirements Agencies CAMELS

Peers

… but because getting it wrong destroys value.)14

Capital Structure – Integration of Capital and Risk Management

15

Mix of securities (Capital Structure) and Risk Management Products

Capital structure optimization is the purpose of risk management – 2 sides of same coinRisk management is capital structure in disguiseRisk management as synthetic or substitute equity

Risk transfer transfer (Cause) Risk Finance (Effect)

Integration of corporate finance and risk management Cost/Benefit analysis regarding use of risk management or

risk financeIssue is whether it is more efficient to (self insure) hold

capital or to use risk management to eliminate the risk cause

(Risk never disappears….

…someone is always on the other side of the trade)

Capital Guidelines

16

S&P: RAC

Very strong >15%

Strong 15/≤ X <10%

Adequate 10 ≤ X < 7%

Moderate 7% ≤ X < 5%

Weak 5% ≤ X < 3%

Very Weak >3%

CAMELS – “C” and “A”:Classified Assets/T1 + ALL

1 - O ≤ X ≤ 25%

2 – 26%< X ≤ 40%

3 - 41% < X ≤ 80%

4 - 81% ≤ X ≤ 100%

5 - > 100

(How much is enough?…

…it depends

Scenarios: To Assess Possible Strategies Against Capital Structure Robustness

17

Financial policy implications:

The upside (U) and base (B) cases generate excess capital which points toward shareholder distributions

The downturn (D) scenario suggests possible changes in risk appetite and the development of appropriate contingency plans to maintain ratios, sell assets and raise capital.

Forward looking Core Tier 1 development under alternative scenarios

U- - - - - - - - - - - - - - - - - - - - - - - - -

B- - - - - - - - - - - - - - - - - - - - - - - - -

D

T

ReturnCapital

Raise/release Capital

Probably

May be

Unlikely

Unlikely

May be

Probably

(Can I survive and tolerate…..

…the worst plausible outcome?)

(Stress testing)

In a ‘sustained severe recession’ scenario, contingency measures may be required to meet target capital ratios

Assumptions Observations Downturn scenario is based on a net profit

decrease of EUR __ bln relative to the reference case to EUR __ bln in __, a drop of __bln to __bln in __ and recovery thereafter.

Decrease in RWA of EUR __ bln in __, __ bln in __ and a __% growth through __ and __ due to lower credit demand and reduction due to FX devaluation.

Divestitures __ according to plan (reference case)

Dividend payout of __ for __, __ thereafter

Share buyback as announced for __ and ongoing neutralisation of stock dividend, but no additional buybacks.

The ratios as presented would trigger a regulatory response as the Tier Total ratio is < __%. Additionally, ratings would be pressured resulting in possible downgrade.

The scenario would lead to a significant shortfall from the 6.0% Core Tier 1 ratio target.

Compared to the mild recession, additional contingency measure to replenish the capital meet target ratios would be required, e.g. Suspend or reduce dividend Suspend stock dividend neutralisation Increase divestment programme18

Sust. Sev. Recession (EUR bln)

YE YE YE YE YE

Net profit

x x x x x

RWA x x x x xCore Tier 1 x x x x x

Gearing x x x x xTier 1 x x x x xTotal BIS

x x x x x

Excess CT1 Capital

x x x x x

Time

Capital Ratios

Elements of Strategy Based Capital Structure Management

19

Choice of Markets with Attractive economics inwhich the organization enjoys a competitive advantage

Risk the organization is willing and able to accept in

pursuit of its strategy

Risks underwritten and retained

Capital relative to Ratings Agencies, Regulators and peersActual Capital

Return capital to shareholders when actual capital exceedsneed, or raise capital when exceeds actual capital

Allocation to business units based on an economiccapital determination

(Risk and capital as inputs into strategic planning….)

(…and not just consequences)

Strategy

Risk Appetite

Risk Assessment

Capital Need and

Capital Assessment

Capital Plan

Capital Allocation

How Much?(Better to be approximately right…

…than precisely wrong.)

20

REITS(29%)

LNYC Pre-Depression

Banks(20%)

Asset Value Losses/Cushion

(7% / 7%)

15-20%Depending on risk of Business Model

High CREDerivatives/ Trading

Conclusion

21

Conclusion

22

Need to incorporate capital structure and risk considerations as an input versus consequence of strategyCapital as cost of riskReturn as cost of capitalRisk as cost of return

Capital structure links strategy, risk and return–represents total risk exposure an organization is capable of accepting and retain in pursuit of its strategy

Market factors have a larger impact on bank capital structure than regulation

(Capital structure as a Process…

… Not a Number)